The Dangers of Quant Trading Models: Dow's 1000 Point Drop a Prime Example

"Build a system that even a fool can use, and only a fool will want to
use it." ~ George Bernard Shaw, 1856-1950, Irish-born British Dramatist

The initial trigger for the drop in the Dow was probably due to fears that
the Greek crisis was going to spread. One could credit this for 300 or maybe
even a 400 point drop in the Dow; however, a 1000 point drop is quite another
matter.

At 2.20Pm the Dow was at 10,460 and then suddenly in 7 minutes it shed another
600 points. Humans could never move that fast. There are rumours that a trader
entered billion instead of million and this triggered the massive sell off.
Whatever the cause the main wave of selling was initiated by computers.

A simplified look at quant models

A Quant (Quantitative) programme is a computer model which determines which
investment strategy is going to yield a superior rate of return; to simplify
matters let's assume the programme decides when to go long or short.. It is
assumed that because computers have no emotions, they should be better at trading
as they can move in and out of the markets extremely rapidly. The scary part
is that the computer renders the final decision. There is one problem, these
computers are programmed by humans and one glitch in the programme can cause
havoc. Let's not forget the old saying junk in junk out. Today's wild action
is indicative of what can go wrong when computers take over.

These quant programs now make the vital function of market marker almost obsolete
and this is a very dangerous situation if left unchecked. Today Treasuries,
SP500 and other indices were moving so fast it was hard to manually follow
them. Computers took over the markets for a few minutes and in that time they
wrecked total havoc. What happens if the glitch is not spotted immediately,
then a cascade of sell orders could be triggered pushing the Dow down until
the circuit breakers kick in. However, if the glitch was not found then computers
would resume selling after the markets opened again. Let's not forget that
big firms can still sell via Dark pools. They are basically electronic
networks that allow big firms to sell stocks without tipping their hand; in
other words, they can sell these stocks anonymously without the public ever
knowing. This is a separate topic, and we will try to cover it another day.
Two examples of firms offering such services are Liquid net Inc., Pipeline.

Quant strategies are becoming extremely popular. They are now accepted in
the investment community and even mutual funds are now using these models.
These models are also known as alpha generators, or alpha gens. These programs
are often set up in advance so that the computer can react instantaneously
to moves in the market. For example, if the Dow drops below a certain level,
the programme can unleash a massive sum of sell orders and in doing so trigger
other quant programs. This could potentially trigger a market meltdown as was
experienced today. Indeed by some counts computers are responsible for as much
as 70% of daily trading volume.

These models are now a real threat to the health of the financial markets
and should be eliminated or closely monitored and regulated. Exchanges should
not cater to firms that are using these programs and openly allow computers
to place orders for millions and or billions of dollars. Exchanges should place
a dollar limit on trades that can be initiated by such programs. One can only
imagine what would happen if the computer mistakenly places a trillion dollar
sell order. Today's action is a warning, next time things could be infinitely
worse. At one point ACN fell from 42.30 to 4 cents, that is 4 cents; it ended
the day at 41.08 down $1.08. PHO dropped from $18 to 10 cents in a matter of
minutes. PG shed $23 dollars in a heartbeat but closed the day down only $1.41.
In between someone could have had a heart attack. Imagine you had 1 million
dollars in ACN, and then suddenly watched your portfolio shrivel right in front
of your eyes as ACN fell to 4 cents from 42 dollars.

One of our first warnings came from Long term capital (LTC). LTC founded in
1994 was one of the most famous Quant based funds and it was run by two noble
prize winning economists: The Quant model did not foresee the Russian government
defaulting on its own debt and this triggered a series of events that destroyed
LTC. In less than 4 months in 1998 LTC lost 4.6 billion dollars. If the Feds
had not stepped in, things could have really turned ugly.

These quant trading programs need to be regulated and not allowed to freely
take over the markets; they are destroying the vital role market makers play
to maintain financial stability in the markets. Today's action should serve
as a wake up call for those who have turned a blind eye to risks these programs
pose to the markets. Next time round we might not be so lucky.

As Jim Rogers puts it "the NYSE should be hanged" and we agree wholeheartedly.
Not only should they be hanged but a 1 billion dollar fine should be imposed
on whoever was responsible for this problem. Officials are stating that they
will only cancel trades where the loss was 60% or more, well what about all
the others who lost in between 20-60%. The greedy bankers get to buy all those
shares at a huge discount and lock in huge profits at the expense of the regular
investors. Outright fraud like this has to be stopped; stiff fines should be
imposed on the perpetrators and the SEC should finally start doing the job
its getting paid for.

"The key to the age may be this, or that, or the other, as the young orators
describe; the key to all ages is -- Imbecility; imbecility in the vast majority
of men, at all times, and, even in heroes, in all but certain eminent moments;
victims of gravity, custom, and fear." ~ Ralph Waldo Emerson, 1803-1882,
American Poet, Essayist

Sol Palha is a market analyst and educator who uses
Mass Psychology, Technical Analysis and Esoteric Cycles to keep you on the
right side of the market. He and his partners are on the web at www.tacticalinvestor.com.

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